Well, the answer to that question is maybe. It depends on a few different circumstances. The income that you’re worried about is called discharge of indebtedness income, and under the Internal Revenue Code, that’s considered income to you, which can be taxed. Under the right circumstances though, you can get out from under that obligation. First, if you were insolvent at the time that your creditor wrote off that debt, then you won’t have to pay tax on it; and what you have to do is fill out a schedule with your tax return demonstrating to the IRS that your debts, including the debt that was written off, exceeded your assets at that time. But a much easier and straightforward way to avoid having discharge of indebtedness income is to do it in a bankruptcy case. The Internal Revenue Code says that debts that are discharged in bankruptcy do not lead to the inclusion of that income in your taxable income. That’s why sometimes strategically, you’ll want to file a bankruptcy to get rid of a significant debt rather than negotiate with a creditor to have them voluntarily release the debt, because in bankruptcy, you’ll never have to pay tax on the discharged indebtedness.
I owed somebody money and they wrote it off. Do I have to pay tax on the amount of money that they discharged?
Ronald J. Drescher has been practicing since 1986 in the areas of business transactions, commercial litigation, loan documentation, bankruptcy, creditors’ rights, and out-of-court workouts. His experience also includes corporate reorganizations, insolvency, business and tax planning.
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